Draining the punch bowl

Wednesday

Jun 26, 2013 at 12:01 AM

A slowly improving economy causes stock prices to plummet. How to figure? Let’s start at the beginning.The financial meltdown of 2008 and the recession that lingered long after prompted the Federal Reserve...

A slowly improving economy causes stock prices to plummet. How to figure? Let’s start at the beginning.

The financial meltdown of 2008 and the recession that lingered long after prompted the Federal Reserve to stimulate the weak economy. It did so by buying Treasury securities and mortgage-backed bonds. Interest rates fell to near zero, a boost for business borrowing money and homebuyers wanting a mortgage.

Companies rode low interest rates to high profits, and investors piled into their stocks. Now the Fed wants to start draining the proverbial punch bowl.

Last Wednesday, Fed Chairman Ben Bernanke announced that the era of cheap borrowing was about to end. Thus, the Fed would start ratcheting back its monthly purchase of Treasuries and mortgage-backed bonds starting later this year. And when the unemployment rate falls to 7 percent — which the Fed thinks will happen next year — the central bank will stop buying them altogether. Unemployment now stands at 7.6 percent.

A few things to keep in mind: Though the economy has improved according to several key statistics, it continues to operate below capacity. The Fed says that interest rates would remain near zero until the unemployment rate reached 6.5 percent. And if inflation remains weak –– the Fed’s chief inflation measure puts it at 1.05 percent — Mr. Bernanke says rates may be held low longer.

Some on Wall Street worry that the Fed may be ending its support of the economy before the economy can grow on its own. That accounts for last week’s sell-off.

But others see the investors’ response as way out of whack. Mr. Bernanke’s message was more subtle than many traders gave it credit for, Gennadiy Goldber, a rate strategist for TD Securities, told The New York Times. “As soon as you give the market anything to chew on, they are going to tear the limb off.”

Mr. Bernanke was himself surprised by the market’s dive after his announcement. Bond prices fell especially hard, causing a sharp rise in interest rates. “We were a little puzzled by that,” the Fed chairman said.

The ride on the Dow Jones roller coaster has been a harrowing one since Mr. Bernanke’s announcement, but ultimately investors will be swayed, not by the fears of the moment, but by whether stocks present a good return on investment in a gradually improving economy.